Leasehold reform Law Commission report – our thoughts

“I bought my flat thinking I own my home outright. It’s a scandal that I don’t”

“The value of my freehold asset should not be reduced by my tenant getting something for less than it is worth to me, or for less than I paid!”

On the one side of the debate are disgruntled leaseholders, many of which were not properly advised or informed when they purchased their property or who have suffered at the hands of some of the more unscrupulous landlords. On the other side are the landlords, many of which acquired their interests having factored into the amount they paid, both the annual income stream and future income potential.

Don’t forget some leaseholders are now freeholders having bought their freehold.  In many cases they will have carried non-participants and could face a financial loss, if latecomers can enfranchise at a lower price.  In other words, not all freeholders are fat cats (but groups of leaseholders, charities, Housing Associations, Local Government, Pension funds etc).  Conversely, many leaseholders are portfolio buy to let landlords who could receive significant windfalls at the expense of other landlords, if the valuations methodology is radically changed.

The arguments are emotive, the answers are largely binary. The likelihood is that whatever the outcome, nobody will be entire happy. No, we’re not discussing Brexit! We’re discussing the potential changes to leasehold reform.

With Brexit day on January 31st (is everyone counting down the days?), the Law Commission published their report on ‘Leasehold Home Ownership: Buying your freehold or extending your lease’ earlier the same month on January 9th.

This article considers the proposed changes, what could happen and what arguably should happen.  

We should caveat this article by advising that it is being written a matter of hours after the report was published. We’ll take a few days to digest hundreds of pages which will throw further light on some of the points we raise in this article.

The two sides in this tightly fought (52-48 anyone?) argument have entrenched positions. The date of the law commissions report was put back, and back, and back (sound familiar?) and now it is finally produced, makes some significant recommendations. Perhaps though as with any poison chalice, the results are somewhat with one foot in one camp and one in the other. Not quite in, not quite out.

The task is now for Government to consider all of the recommendations, choose which ones it wants to pursue and run that particular gauntlet, knowing that it will be a very bumpy ride. Then they’ll need to set out a timescale for the legislative process to enact any reforms. Whatever the outcome, there’s hope there are no extensions to the timescale, ‘flexstensions’ or not. We imagine that there will be a backlog of demands on Parliamentary time due to MPs being busy over the last three years. This backlog may push reforms into the long-grass so we shouldn’t expect any changes very quickly.

Where is the leaseholder?

A strange question but one which forms a hugely significant part of the Law commission reforms.

There are three principle parts to the premium paid for a lease extension or purchase of the freehold interest. The commission accepts that the Term ground rent and the reversionary interest need to be accounted for, albeit as this article will address, the mechanism is in question. However, the third element, the Marriage Value is at question and for this, we have to consider where the leaseholder is in the hypothetical valuation. 

The current position is that if a lease is 80 years or under, Marriage Value applies. The recommendation in what the Law Commission refer to as ‘Scheme 1’ suggests that there will be no Marriage Value payable. Cue utter meltdown from Landlords, large landowners suggesting their asset base has just lost significant amounts and similarly from Housing Associations and pension companies. To a lesser extent also from smaller landlords paid for the future benefit of receiving marriage value when they purchased their interest.

The mid-way recommendation (Scheme 2) doesn’t include Marriage Value but does include Hope Value. The terms aren’t great to be honest. ‘Hope Marriage Value’ would be more accurate. Whilst Marriage Value gives a 50-50 split as it is known that an extension or enfranchisement is required, Hope Marriage Value is only 10-20% for the Landlord. It’s normally used when valuing an interest where there is no request to extend or enfranchise but there is hope that Marriage Value will be payable at some undetermined point in time.  This time, cue the meltdown from both sides. Landlords may be unhappy because they’re not being paid to compensate for a future income they expected when they bought their interest.

The  other recommendation (Scheme 3) is that Marriage Value is not changed at all. Landlords will be happy with the status quo but Leaseholders will be frothing at the mouth that they’re paying a cost they thought could be removed from the statutory calculation.  In this case, there would still be likely to be tweaks with the rest of the valuation exercise but they’d argue that it is Leasehold reform in name only. Again, the Brexit parallels, in this case with Brexit in name only (BRINO) are very apparent.

At this rate, there’ll be no change

If all the variables within leasehold reform are removed and a one size fits all approach adopted, we may need career changes. We’ll forget the journalism option and perhaps opt for comedy. Don’t all laugh at once!

One recommendation is for the capitalisation and deferment rates to be prescribed. Arguably of course, though not prescribed now, there’s very little disagreement between parties on what the appropriate rates are. The Sportelli case has seen to that. Fixing the rates though does present a problem. There are good reasons why rates can be altered at present – the appropriate rate can depend on the circumstances. As wonderful as our Lords & Masters in Parliament are (they may read this), they’re not Valuers. A prescribed rate risks the perfect being the enemy of the plausible.

Another recommendation is for the relativity rate to also be prescribed, through reference to an individual graph, produced by Government. The movement towards AVM instils fear (disclosure of vested interest here – we don’t want to be replaced by an algorithm) and confusion in equal measure. Valuation is an art, sometimes a dark one we grant you. It is however a necessity to ensure that the appropriate graph of relativity or mixture of, with appropriate adjustments is made. What is right for one type of property in one location is not right for another type in another location.

The thought of one graph, written by a grey suit in Whitehall should instil fear in all of us. There is no one size fits all. If there was one graph, the likelihood is that some leaseholders would benefit and others would suffer as a result. The recent Ironhawk and Zucconi cases have been widely disputed in areas outside PCL as being Landlord friendly and contradictory to earlier rulings. If the graph was similar, the benefit leaseholders receive by simplification would be undone by the burden of higher premiums than they may wish to argue in some areas. Whilst not everyone agrees that the Zucconi case ruling is good law, the wonderful thing about precedent is that it can be overturned by further precedent. Challenging or changing legislation is far more difficult. The RICS tried and failed to produce a reliable graph. We’re not sure that the Mandarins of Whitehall will come up with something better.

It must also be remembered that whilst most leasehold reform cases do use the graphs, the starting position should always be market transactions of short leasehold interests. If the evidence is available, the graph may throw up spurious results in comparison. The Mundy case only emphasised the need for comparable market evidence to be considered first. TheIronhawkcase supported the same, even referring to sales 2.81 years before the valuation date as being at the cusp of what is reliable.

Ground rent caps

Onerous ground rent clauses are a big part of the problem that has lead us to the law being reviewed.  Arguably this is a mis-selling scandal as ground rent clauses have often not been explained well, with leaseholders unknowingly submitting themselves to future turmoil. Leaseholders have every right to feel aggrieved. However, landlords will also expect to be compensated for the loss of the ground rent as it stands in the lease. Whether some of them when granting leases reduced their asking prices to account for the ground rent is a moot point that we won’t get into for fear of being shot at from both sides.

One of the recommendations is to cap the treatment of ground rent at 0.1% of the Value. In most cases, that will make very little difference. However, in some cases, the landlord (including many pension companies) could lose out significantly because of this, especially if they have purchased from the developer at market value.  Leaseholders will argue that ground rents should not even exist as owning the property should mean owning it ‘outright’. Landlords will argue that they have a contractual right to receive ground rent so should not lose out if dispossessed of that right.

To develop or not to develop

This is a tricky one which we’ll be intrigued to see how Government play it. The recommendation is to remove any hope value for development on collective enfranchisement cases but require payment to be made in the event that there is future development. This opens up a huge can of worms though. At the point that the new share of freeholders secure planning permission, hope value then increases to actual development value. It’s unclear which is to be paid. What would the valuation date then be? Would there be interest on the payment? If so, how much? What about if the new freeholders subsequently sold onto someone else and they developed? Would the new owners be due to pay the original freeholder? If the original freeholder was a company set up purely to own the freehold, does it need to be kept alive purely for the hope of a further payment or risk the interest becoming bona vacantia? Tracking down the original freeholder may prove difficult if years have passed on. The new owners may want certainty on the payment before they embark on gaining planning permission. There are so many unanswered questions that the unintended consequences may prove prohibitive to actually getting anything done. Government have been known to pass on legislative reform if it proves too difficult and this may be one example.

If it were to happen, the incoming freeholders may see it as a blessing they are acquiring potential without initially paying for it, whilst the existing freeholder may be spitting blood. Particularly so if the development potential is significant and they’re mortgaged to the hilt as a result. What then happens to the mortgage? The term ‘buggers muddle’ has rarely been so apt.

Leaseholders improvements

When leasehold reform is referred to as a dark art, this is definitely one of the issues that springs to mind. The disregarding of improvements has always been one of those issues that doesn’t sit well. Leaseholders argue that it is only right that improvements made are not accounted for in the valuation. After all, why should they be paying twice? However, the problem is exactly what assumptions are made in assessing what the hypothetical condition is. To call it ‘reasonable’ is a disservice to the semblance of case law governing the interpretation.

One answer and indeed the recommendation is to remove the discount altogether. It certainly simplifies matters. However, it would likely increase premiums payable in most instances which is the opposite affect to the stated aim. In some case such as where a flat has been extended or a loft converted to provide further accommodation, the premium could be increased significantly. The current requirements are complicated for a reason. They’re not perfect but they just about work. If Government do mess with them, there may be further unintended consequences.

Favourable premiums for resident owners

This is another unusual one and again, throws up more questions than it provides answers to. We get that it is politically attractive to help resident owners. The Governments practically all out attack on Landlords over the last few years (changes in SDLT, mortgage relief etc) already paints the picture that they’re an easy target. However, should they really have to pay more for the same asset as a resident owner? Flipping that, should the Landlord receive more from a resident owner than a non resident owner? If they were, would the Landlord try and exert some control over who could own the leasehold interest?

The recommended principle of resident owners being treated better is not unusual in the Law. In fact, the Land Compensation Act 1973 sets the Statutory Loss payment for non residents affected by Compulsory Purchase at 2.5% of Market Value lower than resident owners. However, the position is different there in that it is the public sector who are making the payment, enabling the public policy argument to work. In leasehold reform, in most cases, the parties are private individuals or companies. The public sector have little to no involvement. It will be interesting to see what comes out of this change.

The specific recommendation is that Marriage Value cut off point at 80 years could remain for Resident owners but be removed for Landlords. This would mean that a property with say 85 years unexpired would have no Marriage Value for a resident owner but would with a Landlord. The thought process appears to be that this would be an easier pill to swallow when tested against a Human Rights challenge. Landlords may argue that their human rights should not be lower than those of resident owners.

Leasehold reform: The Sequel

Perhaps not the name for a Hollywood blockbuster but those of us in the Industry will eagerly await the Law Commissions further reports that are out later this year. Unless of course there is an extension. The Law Commission will be proposing changes for the leasehold reform processes.

One widely expected change (at least within our office and certainly some others) is the removal of the requirement to wait two years after purchase for a lease extension claim to be submitted. The requirement is a frustrating one at best, often complicated by factors such as the two years starting to tick following registration of the purchase, not the actual purchase date. The two can sometimes be very different and we have known at least a couple of examples where the difference has meant that Marriage Value is unavoidable.  A great deal of stress and unhappiness is due to procedural issues, defective notices and other ‘legal’ bear traps.

Not regularly spoken about but perhaps one change in the process would be clarification on lease extensions for shared ownership properties. Housing Associations who own the majority of these in our experience readily accept lease extension requests, but primarily on a voluntary basis.  The legislation that permits extensions does not include shared ownership properties and clearing this up would prove helpful.

Whose human rights? 

What was quite telling about the Law Commissions report was the regular referrals to Protocol 1 Article 1 (A1P1) of the European Convention of Human Rights.  Schemes 1 and 2 which would give the greatest reduction in costs to premiums are littered with references to A1P1.

The problem that Government have is squaring the circle of what is legally justifiable and what would be seen as fair to the parties involved. Much of the argument behind premiums being too high is because leaseholders believe the process is unfair. Much of the argument behind premiums being correct is because Landlords believe the process is correct in law. Now, we hear you saying ‘well isn’t this about changing the law?’ Absolutely correct, it is! The problem is that it is changing the law to retrospectively affect contracts, themselves legal agreements that were in most cases entered into many years ago. Conversely, what happens to landlords or tenants who have recently purchased theirs asset at the prevailing market value?

Landlords may suggest that leaseholders knew what they were getting into when they entered into those contracts – the leases and the law and valuation practice has been available to examine throughout.  Prices have been paid based on an understanding of the system.  Or at least what should be an understanding of the system, where proper advice is provided. If Landlords interests are interfered with, with their asset values reduced by operation of law, retrospectively affecting contracts entered into many years ago, they could argue that their human rights are interfered with.

However, leaseholders argue that they were not properly advised before entering their contract so did not know what they were getting into. The law may have been available to examine but we’d be surprised if many leaseholders when buying were considering the Leasehold Reform, Housing & Urban Development Act 1993 for example. In June of last year, the Property Ombudsman amended its code to require Estate Agents to advertise things like unexpired terms and ground rents on sales particulars. A fantastic and such a simple idea that many people, including ourselves have called for, for years now. Perhaps it was quite telling that in the same week that the Law Commission report was published, Rightmove suggested to the agents that use its portal that they should be displaying the same. The Ombudsman has been toothless in ensuring compliance and portals such as Rightmove and Zoopla have largely washed their hands of the matter, leaving it up to agents how their platforms are used with only the occasional gentle nudge.

Perhaps legislative reform to require sales particulars to include this information would be sensible? Perhaps even a requirement on solicitors reporting to purchasers to advise on a few set issues, perhaps complimented by a standard RICS advice note. Perhaps, dare we say it, leaseholders should be properly advised what they’re getting into before they get to a point where they are commissioning a Survey report and working out what colour to paint Little Johnny’s bedroom walls.

What will happen next?

The law commission have been very clever here. They’ve taken the approach of summarising the options that would please one side or the other but also suggested that a combination of changes would be required. That combination would ensure that neither side would be particularly happy but it’s vague enough to ensure that nobody can be jumping up and down crying out at their report. They’ve put the ball firmly in Governments court and now it will be for them to consider.

When politicians get involved, we don’t always get logical or sensible decisions (Garden bridge, Millennium Dome anyone?). They don’t always follow logic.

The leaseholder brigade are very vocal and may shout enough about fairness to persuade Government to go with schemes 1 or 2, which could have a significant affect on premiums, leaving Landlords queueing up to express their anger. That may be a politically popular decision.

However, with that decision comes significant Human Rights laws challenges which Government may not want to become embroiled in. As a body, the Landlords are far more able to fund such challenges. As a lobby group, they’re also very well organised and would have a persuasive argument when suggesting that if their asset bases are down-valued, they cannot borrow as much against them and their own development plans could suffer which reduces receipts to the treasury.

It may also be possible of course that Government decides that pushing an issue with such dividing opinions into the long grass may be a good idea. After their experiences with Brexit, picking another contentious subject to legislate on may just be a bridge too far.

A final thought….

With the two sides polarised positions, we suspect that whatever options the Government decide to choose, most people will be unhappy. Whether it’s a soft reform, hard reform, red, white and blue reform or anything else, it’s unlikely that many people will be happy. It’s very unclear whether any middle ground actually exists. Maybe there is only one way to sort such a dilemma. Perhaps we need a peoples vote……..or maybe not!

Written by Richard Stacey MRICS and Dan Knowles MRICS, 10th January 2020